Qualified Legal Compliance Committees: A Useful Tool For Investigating Reports Of Material Violations

An attorney is considered to be 'appearing and practicing before the Commission' when:

• transacting any business with the Commission, including communications in any form;
• representing an issuer in a Commission administrative proceeding or in connection with any Commission investigation, inquiry, information request, or subpoena;
• providing advice in respect of the United States securities laws or the Commission's rules or regulations thereunder regarding any document that the attorney has notice will be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the Commission, including the provision of advice in the context of preparing, or participating in the preparation of, any such document; or
• advising an issuer as to whether information or a statement, opinion, or other writing is required to be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the Commission.

Issuers basically include all companies that are required to file reports with the Commission, including foreign companies, companies in the process of going public and any person controlled by an issuer, such as a wholly-owned subsidiary.

The Upward Reporting Requirements

Reporting Obligation Trigger

The rules provide that an attorney appearing and practicing before the Commission in the representation of an issuer is required to report 'evidence of a material violation' by an issuer or any officer, director, employee or agent of the issuer upward to the issuer's Chief Legal Officer (CLO) or its CLO and chief executive officer (CEO). Key to the foregoing analysis is the following definitions:

• 'Material violation' refers to a material violation of United States securities law or any state securities law, a material breach of a fiduciary duty under federal or state law or a similar material violation of any federal or state law. The Commission indicates that materiality under Section 205 will be the same as generally applied under the U.S. federal securities laws.
• 'Evidence of a material violation' is 'credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occur- red, is ongoing or is about to occur.'

If the attorney believes that it would be 'futile' to report evidence of the material violation to the issuer's CLO and CEO, then the reporting attorney may go up the ladder and directly report the matter to the issuer's audit committee or its full board of directors (without first reporting to the CLO or CEO). Note that the rules do not require an attorney to 'know' of a material violation, but only that it is 'reasonably likely' to occur, and that the attorney's duty is to report the material violation, not affirmatively conduct an investigation of the matter.

Steps Required Once Report Received

Upon receipt of a report of a material violation, the CLO must conduct an inquiry as he or she reasonably believes is necessary to determine whether the material violation alleged in the report has occurred, is occurring or is about to occur or refer the report to a QLCC. If the CLO determines that there is no material violation, then the CLO must notify the reporting attorney of his determination and explain the basis of his determination. If the CLO concludes there is a material violation, then the CLO must take reasonable steps to cause the issuer to make an appropriate response and the CLO must notify the reporting attorney of the remedial measures taken.

A reporting attorney who receives an 'appropriate response' to his report within a reasonable time has no further obligations with respect to his report. However, a reporting attorney that does not receive an 'appropriate response' or does not receive any response within a reasonable period of time is required to go 'up the ladder' and report the evidence to the issuer's audit committee (if there is no audit committee, then to a committee of nonemployee directors and, if there is not a committee of nonemployee directors, then to the full board of directors).

An 'appropriate response' is a response that provides a basis for an attorney to reasonably believe that:

• no material violation has occurred, is occurring or is about to occur;
• the issuer has adopted appropriate remedial measures; or
• the issuer, with consent of the board, an independent committee of the board or a QLCC, has retained or directed an attorney to review the reported evidence and either has:
  • substantially implemented any remedial measures recommended by such attorney after a reasonable investigation and evaluation; or
  • been advised that the issuer may assert a 'colorable defense' in any investigation or proceeding relating to the reported evidence.

An attorney's evaluation of whet- her a response is appropriate is measured against a reasonableness standard that permits the attorney to account for all attendant circumstances, including the weight of the evidence of a material violation, the severity of the alleged material violation and the scope of the investigation into the report.

The Commission has proposed rules that if adopted would impose additional duties on a reporting attorney who fails to receive an appropriate response or any response from the audit committee or other committee of the board. (See 'The 'Noisy Withdrawal' and 'Reporting Out' Proposals' discussed below.)

Qualified Legal Compliance Committees

The rules provide attorneys with an alternative method of reporting evidence of a material violation and CLOs with an alternative method of responding to a report. Rather than reporting evidence of a material violation to the CLO, an attorney may satisfy all of his upward reporting obligations by reporting such evidence directly to a previously established QLCC of the issuer. Importantly, an attorney that reports evidence of a material violation directly to the QLCC is not required to assess the reasonableness of the issuer's response to the reported evidence. Similarly, a CLO that receives a report may ask the QLCC to investigate the report in lieu of conducting his own investigation, and such CLO will no longer be responsible to respond to the evidence or to report back to the reporting attorney, except to inform the reporting attorney that the report has been referred to the QLCC.

A QLCC is a committee of an issuer that consists of at least one member of the issuer's audit committee (or a member of an equivalent committee of independent directors if the issuer does not have an audit committee) and two or more members of the issuer's board of directors that are not employed by the issuer. Since the Commission has indicated that it may require all QLCC members to satisfy independence standards for directors once the standards go into effect, issuers should consider utilizing directors for its QLCC that would satisfy the proposed independence standards. In lieu of establishing a new committee, an issuer may designate its audit committee or other independent committee to be the QLCC so long as this existing committee satisfies the requirements.

The rules also require i) a QLCC to adopt written procedures for the confidential receipt, retention, and consideration of any report of evidence of a material violation, and ii) the QLCC to have been duly established by the issuer's board of directors, with the authority and responsibility, to do the following:

• Inform the issuer's CLO and CEO of any report of evidence of a material violation.
• Determine whether an investigation is necessary regarding any report of evidence of a material violation by the issuer, its officers, directors, employees or agents and, if it determines an investigation is necessary or appropriate, to:
  • notify the audit committee or the full board of directors;
  • initiate an investigation, which may be conducted either by the CLO or by outside attorneys; and
  • retain such additional expert personnel as the committee deems necessary; and
• At the conclusion of any such investigation, to:
  • recommend, by majority vote, that the issuer implement an appropriate response to evidence of a material violation; and
  • inform the CLO, CEO and the board of directors of the results of any such investigation under this section and the appropriate remedial measures to be adopted.
• Acting by majority vote, to take all other appropriate action, including the authority to notify the Commission in the event that the issuer fails in any material respect to implement its recommendations.

The Commission encourages, but does not require, issuers to adopt a QLCC as part of an effective corporate governance strategy. The Commission does not intend for service on a QLCC to increase a director's liability under state law, but rather states that for a court to conclude that service on a QLCC would be a basis for increasing a director's liability would be against public interest.

The 'Noisy Withdrawal' and 'Reporting Out' Proposals

As originally proposed by the Commission, the rules included a 'noisy withdrawal' provision that required outside counsel who had not received an appropriate response or no response to a report of a material violation within a reasonable time after upward reporting to the audit committee or the full board (other than the QLCC) to, under certain conditions, withdraw 'forthwith' from representing the issuer, provide written notice to the Commission within one business day indicating that the withdrawal was based on 'professional considerations' and to disaffirm certain documents filed previously with the Commission that the reporting attorney believes to be false or misleading. A reporting attorney that is an employee of the issuer is not required to resign, but is required to notify the Commission of his intent to disaffirm any and all documents that have been filed or submitted to the Commission that he believes to be tainted.

The Commission has extended the comment period on the 'noisy withdrawal' proposal and has proposed an alternative 'reporting out' proposal. The 'reporting out' proposal requires an issuer, not the reporting attorney, to disclose within two business days that a reporting attorney has withdrawn from representation of the issuer because the issuer failed to provide the attorney with an appropriate response to the attorney's report of evidence of a material violation in a reasonable time. If an attorney employed by the issuer made the report and did not receive an appropriate response, the 'reporting out' proposal requires the attorney to cease assisting or participating in any matter related to the violation and notify the issuer in writing that they did not receive an appropriate response in a reasonable time. The issuer is required to disclose receipt of such notice from any employee attorney within two business days.

Under the proposed rules, the 'noisy withdrawal' and 'reporting out' provisions are inapplicable when a reporting attorney reports evidence of a material violation to the QLCC. In such circumstance, the QLCC is responsible for notifying the Commission if the issuer fails to implement an appropriate response recommended by the QLCC.

Conclusion

Since the QLCC, and not the reporting attorney or CLO, has the ultimate responsibility with respect to a report of a material violation once such a report has been submitted to the QLCC, the establishment of a QLCC shifts a great deal of the responsibility and burden with respect to handling such matters to the QLCC and away from the individual reporting attorney and CLO. This dynamic may allow issuers to more closely control and institutionalize this critical reporting process and provide a more efficient and expedient way to examine these issues in time sensitive situations. Additionally, reporting attorneys will not be subject to the 'noisy withdrawal' or 'reporting out' provisions, as proposed, if an attorney elects to report evidence of material violations to the issuer's QLCC. Because the QLCC alternative is available only if the QLCC is established prior to a report of evidence of a material violation, companies should promptly discuss forming a QLCC with their boards and establish a QLCC if deemed appropriate. As part of this analysis, issuers need to consider whether to use an audit committee or newly formed committee as the QLCC, who will be designated as the CLO and educate all attorneys (including those who might work on contracts that are filed with the Commission) of the parameters of and responsibility under the new rules.

Daryl L. Lansdale, Jr. is a Partner and Derrek Weaver is an associate at Fulbright & Jaworski L.L.P. in San Antonio, TX.

Section 307 of the Sarbanes-Oxley Act of 2002 requires the Securities and Exchange Commission (Commission) to adopt new standards governing the conduct of attorneys who represent public companies before the Commission. On January 23, 2003, the Commission adopted final rules to implement Section 307. The rules, which become effective on August 5, 2003, establish minimum standards of professional conduct for attorneys appearing and practicing before the Commission in the representation of an issuer as well as reporting procedures that must be followed if an attorney becomes aware of a 'material violation.' As discussed herein, establishing a Qualified Legal Compliance Committee (QLCC) could save issuers valuable time and create a more controlled and efficient process in identifying and rectifying potential material violations.

Who is Covered by the New Rules?

Subject to certain limited exceptions, the rules impose upward reporting obligations on attorneys who 'appear and practice before the Commission' in 'the representation of an issuer.' The definition of 'attorney' covers both outside counsel and attorneys employed by an issuer.

An attorney is considered to be 'appearing and practicing before the Commission' when:

• transacting any business with the Commission, including communications in any form;
• representing an issuer in a Commission administrative proceeding or in connection with any Commission investigation, inquiry, information request, or subpoena;
• providing advice in respect of the United States securities laws or the Commission's rules or regulations thereunder regarding any document that the attorney has notice will be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the Commission, including the provision of advice in the context of preparing, or participating in the preparation of, any such document; or
• advising an issuer as to whether information or a statement, opinion, or other writing is required to be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the Commission.

Issuers basically include all companies that are required to file reports with the Commission, including foreign companies, companies in the process of going public and any person controlled by an issuer, such as a wholly-owned subsidiary.

The Upward Reporting Requirements

Reporting Obligation Trigger

The rules provide that an attorney appearing and practicing before the Commission in the representation of an issuer is required to report 'evidence of a material violation' by an issuer or any officer, director, employee or agent of the issuer upward to the issuer's Chief Legal Officer (CLO) or its CLO and chief executive officer (CEO). Key to the foregoing analysis is the following definitions:

• 'Material violation' refers to a material violation of United States securities law or any state securities law, a material breach of a fiduciary duty under federal or state law or a similar material violation of any federal or state law. The Commission indicates that materiality under Section 205 will be the same as generally applied under the U.S. federal securities laws.
• 'Evidence of a material violation' is 'credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occur- red, is ongoing or is about to occur.'

If the attorney believes that it would be 'futile' to report evidence of the material violation to the issuer's CLO and CEO, then the reporting attorney may go up the ladder and directly report the matter to the issuer's audit committee or its full board of directors (without first reporting to the CLO or CEO). Note that the rules do not require an attorney to 'know' of a material violation, but only that it is 'reasonably likely' to occur, and that the attorney's duty is to report the material violation, not affirmatively conduct an investigation of the matter.

Steps Required Once Report Received

Upon receipt of a report of a material violation, the CLO must conduct an inquiry as he or she reasonably believes is necessary to determine whether the material violation alleged in the report has occurred, is occurring or is about to occur or refer the report to a QLCC. If the CLO determines that there is no material violation, then the CLO must notify the reporting attorney of his determination and explain the basis of his determination. If the CLO concludes there is a material violation, then the CLO must take reasonable steps to cause the issuer to make an appropriate response and the CLO must notify the reporting attorney of the remedial measures taken.

A reporting attorney who receives an 'appropriate response' to his report within a reasonable time has no further obligations with respect to his report. However, a reporting attorney that does not receive an 'appropriate response' or does not receive any response within a reasonable period of time is required to go 'up the ladder' and report the evidence to the issuer's audit committee (if there is no audit committee, then to a committee of nonemployee directors and, if there is not a committee of nonemployee directors, then to the full board of directors).

An 'appropriate response' is a response that provides a basis for an attorney to reasonably believe that:

• no material violation has occurred, is occurring or is about to occur;
• the issuer has adopted appropriate remedial measures; or
• the issuer, with consent of the board, an independent committee of the board or a QLCC, has retained or directed an attorney to review the reported evidence and either has:
  • substantially implemented any remedial measures recommended by such attorney after a reasonable investigation and evaluation; or
  • been advised that the issuer may assert a 'colorable defense' in any investigation or proceeding relating to the reported evidence.

An attorney's evaluation of whet- her a response is appropriate is measured against a reasonableness standard that permits the attorney to account for all attendant circumstances, including the weight of the evidence of a material violation, the severity of the alleged material violation and the scope of the investigation into the report.

The Commission has proposed rules that if adopted would impose additional duties on a reporting attorney who fails to receive an appropriate response or any response from the audit committee or other committee of the board. (See 'The 'Noisy Withdrawal' and 'Reporting Out' Proposals' discussed below.)

Qualified Legal Compliance Committees

The rules provide attorneys with an alternative method of reporting evidence of a material violation and CLOs with an alternative method of responding to a report. Rather than reporting evidence of a material violation to the CLO, an attorney may satisfy all of his upward reporting obligations by reporting such evidence directly to a previously established QLCC of the issuer. Importantly, an attorney that reports evidence of a material violation directly to the QLCC is not required to assess the reasonableness of the issuer's response to the reported evidence. Similarly, a CLO that receives a report may ask the QLCC to investigate the report in lieu of conducting his own investigation, and such CLO will no longer be responsible to respond to the evidence or to report back to the reporting attorney, except to inform the reporting attorney that the report has been referred to the QLCC.

A QLCC is a committee of an issuer that consists of at least one member of the issuer's audit committee (or a member of an equivalent committee of independent directors if the issuer does not have an audit committee) and two or more members of the issuer's board of directors that are not employed by the issuer. Since the Commission has indicated that it may require all QLCC members to satisfy independence standards for directors once the standards go into effect, issuers should consider utilizing directors for its QLCC that would satisfy the proposed independence standards. In lieu of establishing a new committee, an issuer may designate its audit committee or other independent committee to be the QLCC so long as this existing committee satisfies the requirements.

The rules also require i) a QLCC to adopt written procedures for the confidential receipt, retention, and consideration of any report of evidence of a material violation, and ii) the QLCC to have been duly established by the issuer's board of directors, with the authority and responsibility, to do the following:

• Inform the issuer's CLO and CEO of any report of evidence of a material violation.
• Determine whether an investigation is necessary regarding any report of evidence of a material violation by the issuer, its officers, directors, employees or agents and, if it determines an investigation is necessary or appropriate, to:
  • notify the audit committee or the full board of directors;
  • initiate an investigation, which may be conducted either by the CLO or by outside attorneys; and
  • retain such additional expert personnel as the committee deems necessary; and
• At the conclusion of any such investigation, to:
  • recommend, by majority vote, that the issuer implement an appropriate response to evidence of a material violation; and
  • inform the CLO, CEO and the board of directors of the results of any such investigation under this section and the appropriate remedial measures to be adopted.
• Acting by majority vote, to take all other appropriate action, including the authority to notify the Commission in the event that the issuer fails in any material respect to implement its recommendations.

The Commission encourages, but does not require, issuers to adopt a QLCC as part of an effective corporate governance strategy. The Commission does not intend for service on a QLCC to increase a director's liability under state law, but rather states that for a court to conclude that service on a QLCC would be a basis for increasing a director's liability would be against public interest.

The 'Noisy Withdrawal' and 'Reporting Out' Proposals

As originally proposed by the Commission, the rules included a 'noisy withdrawal' provision that required outside counsel who had not received an appropriate response or no response to a report of a material violation within a reasonable time after upward reporting to the audit committee or the full board (other than the QLCC) to, under certain conditions, withdraw 'forthwith' from representing the issuer, provide written notice to the Commission within one business day indicating that the withdrawal was based on 'professional considerations' and to disaffirm certain documents filed previously with the Commission that the reporting attorney believes to be false or misleading. A reporting attorney that is an employee of the issuer is not required to resign, but is required to notify the Commission of his intent to disaffirm any and all documents that have been filed or submitted to the Commission that he believes to be tainted.

The Commission has extended the comment period on the 'noisy withdrawal' proposal and has proposed an alternative 'reporting out' proposal. The 'reporting out' proposal requires an issuer, not the reporting attorney, to disclose within two business days that a reporting attorney has withdrawn from representation of the issuer because the issuer failed to provide the attorney with an appropriate response to the attorney's report of evidence of a material violation in a reasonable time. If an attorney employed by the issuer made the report and did not receive an appropriate response, the 'reporting out' proposal requires the attorney to cease assisting or participating in any matter related to the violation and notify the issuer in writing that they did not receive an appropriate response in a reasonable time. The issuer is required to disclose receipt of such notice from any employee attorney within two business days.

Under the proposed rules, the 'noisy withdrawal' and 'reporting out' provisions are inapplicable when a reporting attorney reports evidence of a material violation to the QLCC. In such circumstance, the QLCC is responsible for notifying the Commission if the issuer fails to implement an appropriate response recommended by the QLCC.

Conclusion

Since the QLCC, and not the reporting attorney or CLO, has the ultimate responsibility with respect to a report of a material violation once such a report has been submitted to the QLCC, the establishment of a QLCC shifts a great deal of the responsibility and burden with respect to handling such matters to the QLCC and away from the individual reporting attorney and CLO. This dynamic may allow issuers to more closely control and institutionalize this critical reporting process and provide a more efficient and expedient way to examine these issues in time sensitive situations. Additionally, reporting attorneys will not be subject to the 'noisy withdrawal' or 'reporting out' provisions, as proposed, if an attorney elects to report evidence of material violations to the issuer's QLCC. Because the QLCC alternative is available only if the QLCC is established prior to a report of evidence of a material violation, companies should promptly discuss forming a QLCC with their boards and establish a QLCC if deemed appropriate. As part of this analysis, issuers need to consider whether to use an audit committee or newly formed committee as the QLCC, who will be designated as the CLO and educate all attorneys (including those who might work on contracts that are filed with the Commission) of the parameters of and responsibility under the new rules.

Daryl L. Lansdale, Jr. is a Partner and Derrek Weaver is an associate at Fulbright & Jaworski L.L.P. in San Antonio, TX.